DERIVATIVES – THE GLOBAL CASINO

Prepared by:
Name : Jai Kumar Dungarwal
Roll No. : 190
Room No. : 11
Registration No. : – A01-1112-1079-12
Session : 2012-2015
Under the supervision of :
Prof. Abhinab Ghosh, Faculty,
Accounting & Finance, St. Xavier’s College

(Space for project completion certificate)

Jai Kumar Dungarwal
Roll No. : 0190

Page 2

DECLARATION
I, the undersigned, Jai Kumar Dungarwal, student of B.Com. (Honours)
at St. Xavier’s College (Autonomous), Kolkata declare that I have
completed this Project on “Derivatives – The Global Casino” in the
Academic Year 2014-2015.

Date:
Place: Kolkata
Jai Kumar Dungarwal
Roll No. : 0190

(Signature)

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without whose blessings and motivation this project would be possible to complete. Prof. : 0190 Page 4 . Jai Kumar Dungarwal Roll No.ACKNOWLEDGEMENT I would like to express my sincere gratitude to St. resourceful and learning process of Project Preparation and Research Work. Abhinab Ghosh. patiently removing any scope of doubt and helping me with his valuable suggestions. providing me with valuable inputs. Xavier’s College for providing me an opportunity to present this project. Finally. I would like to thank all my friends who have constantly helped me during the course of this project work. I would like to extend a deep gratitude towards my project guide. Dominic Savio for constantly motivating and encouraging us and giving the students an opportunity to indulge ourselves in this informative. for always being there for help. A very sincere thank you to our vice principal Fr. I would like to thank my parents.

Jai Kumar Dungarwal Roll No. : 0190 Page 5 .

3 3 3.9 8 8.1.1 1. 1 1.TABLE OF CONTENTS Sl.1 5 6 7 7.2 8.1.1. no.4 9 10 11 11 12 PARTICULARS INTRODUCTION OBJECTIVES RESEARCH METHODOLOGY LIMITATIONS OF THE STUDY SCOPE OF THE STUDY DERIVATIVES TYPES OF DERIVATIVES RISK CHARACTERISTICS OF DERIVATIVES FACTORS FOR THE GROWTH OF THE DERIVATIVES FUTURES FUTURES IN INDIA PAYOFF FOR FUTURES OPTIONS OPTIONS PAYOFF HEDGING HEDGING USING FUTURES HEDGING USING OPTIONS STRATEGIES UNDER OPTIONS LONG CALL SYNTHETIC LONG CALL SHORT PUT LONG COMBO COVERED CALL LONG STRADDLE COLLAR BULL CALL SPREAD SHORT CALL BUTTERFLY DERIVATIVES IN INDIA EQUITY DERIVATIVES IN INDIA OPERATORS OF DERIVATIVES MARKET REGULATION OF DERIVATIVES TRADING IN INDIA INDIAN DERIVATIVES VIS-À-VIS GLOBAL DERIVATIVES QUESTIONNAIRE ANALYSIS FINDINGS & SUGGESTIONS CONCLUSIONS BIBLIOGRAPHY Jai Kumar Dungarwal Roll No.2 4 4.3 8.1.1 7.1 2.1.1.4 2 2.1.5 7.1.8 7.3 1. : 0190 PAGE NO 7-9 7 7-8 8 9 9-13 11 12 13 13-18 16 18 20-21 21 27-28 28-29 30-31 31-43 31 32 34 35 36 38 39 41 42 44-50 45 49 50 50 51 53-59 60-61 62 63 Page 6 .1 3.3 7.1 8.6 7.1 7.1.4 7.2 7.7 7.2 2.2 1.

1. Options and Futures are traded actively on many exchanges. more basic.1.  To understand the scope of derivatives market in India. 1. Secondary sources:The data for study has been collected from various sources: Books Jai Kumar Dungarwal Roll No. banks and their corporate clients in what are termed as over-the-counter markets – in other words. Exploratory and Analytical in nature. Method of data collection:Primary Data – A sample survey was done based on a set of questionnaire given to some students of Accounting & Finance Department. Introduction A Derivative is a financial instrument whose value depends on other. An attempt has been made to collect the maximum facts and figures available on Derivatives. underlying variables. Forward contracts. there is no single market place or organized exchanges.  To study how hedging is an effective tool of derivatives market and various risk and return appetites under various strategies that can be used for hedging.  To understand equity derivatives from the view point of futures and options in the Indian market and various strategies that can be applied by traders and investors. Swap and different types of options are regularly traded outside exchanges by financial institutions. : 0190 Page 7 . Derivatives have become increasingly important in the field of finance. The variables underlying could be prices of traded securities and stock.1 OBJECTIVES OF THE STUDY  To understand the concept of derivatives and insight view of Indian derivatives market.2 RESEARCH METHODOLOGY The Research is Descriptive. prices of gold or copper.

3 LIMITATIONS: LIMITED TIME: Time is a major constraint. ASPECTS COVERAGE: Some of the aspects may not be covered and hypothetical cases are taken for understanding various strategies applicable for hedging. : 0190 Page 8 .Journals Internet sources Statistical Tools Used:  Simple tools like bar graphs. Jai Kumar Dungarwal Roll No. PRIMARY DATA COLLECTION: The primary data could not be collected from fund managers and those trading regularly in the derivatives market as the concerned persons did not want to disclose anything about the strategy that they follow. 1. as research type in depth study of each instrument under derivatives and each strategy under various instruments cannot be done. line diagrams have been used. tabulation. VOLATILITY: Stock market is so much volatile and it is difficult to forecast anything about it whether you trade through online or offline.

Jai Kumar Dungarwal Roll No. The underlying asset may be in the form of equity. farmers would face price uncertainty.4 SCOPE OF THE STUDY  As derivatives are a very vast & huge subject the scope of research is limited to the financial derivatives viz. Derivatives are a product whose value is derived from one or more variable of an underlying asset in a contractual manner. the market for financial derivatives has grown tremendously both in terms of variety of instruments available.1. These were simple contracts developed to meet the needs of farmers and were basically a mean of reducing risk. interest rate. Through the use of simple derivative products. futures and options on stock indices have gained more popularity than on individual stocks. bonds and various other assets.  The period covered is 2001-02 to 2013-14. commodity. futures & options . In recent years. Various instruments engaged in financial and capital markets come with different risk attached to it. it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. In the class of equity derivatives. The lower costs associated with index derivatives vis-a-vis derivative products based on individual securities is another reason for their growing use. 2. The emergence of the market for derivative products can be traced to the willingness of the risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. It is the existence of risk coupled with various sentiments of investors and their risk taking abilities that has given rise to Derivatives market. From the time it was sown to the time it was ready to harvest. especially among institutional investors. DERIVATIVES: “Risk” is an inseparable part of investing in financial and capital markets. foreign exchange. who are major users of index-linked derivatives. The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. their complexity and also turnover.  Forward have been kept out of scope of research as they are not used as effective tool for hedging in equity derivatives market. : 0190 Page 9 .

Jai Kumar Dungarwal Roll No. share. loan whether secured or unsecured. without going through an exchange or other intermediary. forward rate agreements and exotic options are almost always traded in this way.In the Indian context the Securities Contracts (Regulation) Act. or index of prices. risk instrument or contract for differences or any other form of security”. Products such as swaps. A contract. Exchange-traded derivatives are those derivatives products that are traded via Derivatives exchanges. The derivatives are securities under the SC(R) A and hence the trading of derivatives is governed by the regulatory framework under the SC(R) A. 1956 (SC(R) A) defines “equity derivative” to include – “A security derived from a debt instrument. A derivatives exchange acts as an intermediary to all transactions. which derives its value from the prices. of underlying securities. There are two distinct groups of Derivative:• • Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties. The OTC derivatives market is huge. : 0190 Page 10 . and takes Initial margin from both sides of the trade to act as a guarantee.

Two main types of options are call option and put option. futures and options which would are discussed in detailed later. Various types of commonly traded derivatives are:  Forwards: A forward contract is basically contract between two entities at some future date. at an agreed price and quantity today.  Options: Options are the contracts between two parties at certain future agreed price where the buyer of the contract have the right but not obligation to exercise the contract at the date of expiration of contract or before that. The contract price is generally traded over the counter and is not available in public domain and contract is settled by physical delivery of asset on some future date.2. The primary difference between futures and forwards are former is traded over the counter whereas latter are exchange traded contracts.1 TYPES OF DERIVATIVES CLASSIFICATION OF DERIVATIVES Exchange Traded Derivatives Over The Counter Derivatives Swaps National Stock Exchange Bombay Stock Exchange National Commodity & Derivative Exchange Index Future Index option Stock option Stock future Interest rate future The most commonly used derivatives contracts are forwards. Options are exchange latter traded contracts.  Futures: Futures contracts are type of forward contracts between two parties to buy or sell an asset in certain future agreed date and price. Jai Kumar Dungarwal Roll No. : 0190 Page 11 .

These are options having a maturity of upto three years. The underlying asset is usually a moving average or a basket of assets. Swaps: Swaps are a popular financing tool. Currency swaps: These entail swapping both principal and interest between the parties. etc.  Market risk: This type of risk is concerned with various price movements taking place in stock market.  Warrants: Options generally have lives of upto one year.  Liquidity risk: The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk and is mainly related to liquidity of separate products and funding of activities of the firm including derivatives. commodities. Various risks attached with derivatives are:  Credit risk: It is mainly concerned with counterparty on non performance of contract which is also known as default or credit party risk. : 0190 Page 12 . Various variants of swaps are currency.2 RISK CHARACTERISTICS OF DERIVATIVES There are various risks attached in financial transactions and derivatives are used for separate risks from traditional instruments. 2. Longer-dated options are called warrants and are generally traded over-the-counter. interest rate. with the cash flows in one direction being in a different currency than those in the opposite direction. Jai Kumar Dungarwal Roll No. Equity index options are a form of basket options.  Baskets: Basket options are options on portfolios of underlying assets. the majority of options traded on options exchanges having a maximum maturity of nine months. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.  LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. a contract between two parties (counter parties) to exchange two streams of payment for an agreed period of time.

network systems and enhanced method of data entry.  GLOBALISATION OF MARKETS :Earlier. 2. Such change in the price is known as ‘price volatility’. what happened in other part of the world was mostly irrelevant.  TECHNOLOGICAL ADVANCES :A significant growth of derivative instruments has been driven by technological breakthrough. the frequency of price changes and the magnitude of price changes. In a market. Advances in this area include the development of high speed processors. in many cases. : 0190 Page 13 . These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Legal risk: Derivatives are traded not only within the jurisdiction of the country but also with other countries and hence legal aspects associated with various deals should be looked in carefully. led to cut profit margins. Data transmission by satellite. Improvement in communications allow for instantaneous worldwide conferencing. These factors are constantly interacting in the market causing changes in the price over a short period of time. and the collective interaction of demand and supply in the market determines the price. Globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. Now globalization has increased the size of markets and as greatly enhanced competition . managers had to deal with domestic economic concerns. It has also exposed the modern business to significant risks and. consumers have ‘demand’ and producers or suppliers have ‘supply’. Jai Kumar Dungarwal Roll No.it has benefited consumers who cannot obtain better quality goods at a lower cost.3 FACTORS CONTRIBUTING FOR THE GROWTH OF DERIVATIVES  PRICE VOLATILITY :Prices are generally determined by market forces. This factor alone has contributed to the growth of derivatives to a significant extent. This has three factors: the speed of price changes.

a fixed number of barrels of oil. In case of physical commodities. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970’s. either cash settlement or physical settlement.  The currency in which the futures contract is quoted. etc. this specifies which bonds can be delivered. In case of bonds. The delivery month. BASIC FEATURES OF FUTURES CONTRACT 1.  The grade of the deliverable. Unlike forward contracts. the notional amount of the deposit over which the short term interest rate is traded.  Other details such as the tick. This can be the notional amount of bonds. This can be anything from a barrel of sweet crude oil to a short term interest rate.  The last trading date. the exchange Jai Kumar Dungarwal Roll No. ADVANCES IN FINANCIAL THEORIES :Advances in financial theories gave birth to derivatives. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. a standard quantity and quality of the underlying instrument that can be delivered and a standxard timing of such settlement. FUTURES The futures markets were designed to solve the problem that exists in the forward market. who always acts as counterparty. the minimum permissible price fluctuation. 3. its price constantly fluctuates. Initially forward contracts in its traditional form. work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures.  The type of settlement. this specifies not only the quality of the underlying goods but also the manner and location of delivery. usually by specifying:  The underlying. Margin: Although the value of a contract at time of trading should be zero. and creates a credit risk to the exchange. the future contracts are standardized and exchange traded. A futures contract may be exercised prior to maturity by entering in to equal and opposite transaction. 2. : 0190 Page 14 . This renders the owner liable to adverse changes in value.  The amount and units of the underlying asset per contract. It is a standardized contract with standard underlying instrument. was the only hedging tool available. units of foreign currency. To minimize this risk. Standardization: Futures contracts ensure their liquidity by being highly standardized.

usually called variation or maintenance margin. • Cash settlement . This is intended to protect the exchange against loss.that is.a cash payment is made based on the underlying reference rate. called the "settlement" or mark-to-market price of the contract. the contract is marked to its present market value. Initial margin: is paid by both buyer and seller. such as a short term interest rate index such as Euribor. and can be done in one of two ways. as specified per type of futures contract: • Physical delivery . For many equity index and interest rate futures contracts. a further margin. deposits money with the exchange.demands that contract owners post a form of collateral.the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange. This is calculated by the futures contract. and the exchange pays this profit into his account. buying a contract to cancel out an earlier sale (covering a short). which is not likely to be exceeded on a usual day's trading. called a "margin". Expiry is the time when the final prices of the future are determined. In practice. it occurs only on a minority of contracts. consider that a futures trader. Jai Kumar Dungarwal Roll No. as determined by historical price changes. is required by the exchange.e. Settlement Settlement is the act of consummating the contract. this happens on the Last Thursday of certain trading month. On the other hand. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin. At the end of every trading day. It may be 5% or 10% of total contract price. : 0190 Page 15 . commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. then the margin is used as the collateral from which the loss is paid. On this day the t+2 futures contract becomes the t forward contract. if he is on the losing side. To understand the original practice. the exchange will debit his account. It represents the loss on that contract. If he cannot pay. A futures contract might also opt to settle against an index based on trade in a related spot market. If the trader is on the winning side of a deal. or the closing value of a stock market index. i. agreeing on a price at the end of each day. when taking a position. 3. or selling a contract to liquidate an earlier purchase (covering a long). his contract has increased in value that day. and by the exchange to the buyers of the contract. Most are cancelled out by purchasing a covering position .

BSE SENSEX FUTURES The underlying for the Sensex Futures is the BSE Sensitive Index of 30 scripts. S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle . the next month (two) and the far month (three). the contracts shall expire on the previous trading day & the permitted lot size of S&P CNX NIFTY contracts is 200 and multiples.3. 2000. popularly called the Sensex. The NIFTY futures contracts are based on the popular market benchmark S&P CNX NIFTY Index. Jai Kumar Dungarwal Roll No. If the last Thursday is a trading holiday. : 0190 Page 16 . A new contract will be introduced on the trading day following the expiry of the near month contract. S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month.the near month (one).1 FUTURES IN INDIA The National Stock Exchange commenced trading in Index Futures on 12 June. The contract multiplier is 50 which mean the Rupee notional value of a futures contract would be 50 times the contracted value.

426 7.596.065.809.745 8.25 95.913 6.236 2.67 11 NIFTY February 2014 140617 4595362 5.251 100.73 6 NIFTY November 2013 188152 6106099 6.70 7 NIFTY May 2013 181338 6019855 6.24 4 NIFTY January 2014 191.843 8.74 3 NIFTY October 2013 231.88.079 2.38 19 BANKNIFTY November 2013 66..01 12 NIFTY April 2013 118765 4188277 4.498 9.96 9 NIFTY December 2013 164155 5253648 5.Top 20 Futures contracts according to number of contracts 2013-14 Sl.99 2 NIFTY September 2013 245.60 17 BANKNIFTY March 2014 72452 2458223 2.02 14 BANKNIFTY October 2013 78292 2966124 2.84 10 NIFTY March 2014 159345 4931435 5.35 20 BANKNIFTY December 2013 63.378 2.83 5 NIFTY June 2013 189063 6492384 6. : 0190 Page 17 .64 16 BANKNIFTY January 2014 73103 2646175 2.46 8 NIFTY July 2013 167505 5687503 5.815 6.208.79 15 BANKNIFTY September 2013 74222 3001290 2.969.614 8.23 13 BANKNIFTY August 2013 84724 3484170 3.119 (Source: NSE Factbook 2014 issue) Jai Kumar Dungarwal Roll No.028 8.No. Name of the Contract Number of Contracts (crores) Turnover (crores) Percentage of contracts to Top 20 contracts 1 NIFTY August 2013 252.131.00 TOTAL 2.58 18 BANKNIFTY May 2013 66726 2102706 2.070 23.645.

2 Payoff for futures Futures contracts have linear payoffs. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. The underlying asset in this case is the Nifty portfolio. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. it starts making losses. When the index moves up. In simple words. Figure A: Payoff for a buyer of Nifty futures Jai Kumar Dungarwal Roll No. The underlying asset in this case is the Nifty portfolio. and when the index moves down it starts making losses. the long futures position starts making profits.FUTURES TERMINOLOGIES • SPOT PRICE: The price at which an asset trades in the spot market. • FUTURES PRICE: The price at which the futures contracts trade in the futures market. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. the short futures position starts making profits. He has a potentially unlimited upside as well as a potentially unlimited downside. : 0190 Page 18 . He has a potentially unlimited upside as well as a potentially unlimited downside. it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. and when the index moves up. When the index moves down. Figure B shows the payoff diagram for the seller of a futures contract. Below Figure A shows the payoff diagram for the buyer of a futures contract. 3.

his futures position starts showing losses. If the index goes up. The investor sold futures when the index was at 1220. If the index goes down.The figure below shows the profits/losses for a long futures position. his futures position starts making profit. Profit 0 1220 Nifty Loss Figure B: Payoff for a seller of Nifty futures The figure shows the profits/losses for a short futures position. Profit 1220 0 Nifty Loss Jai Kumar Dungarwal Roll No. his futures position starts making profit. The investor bought futures when the index was at 1220. If the index rises. : 0190 Page 19 . If the index falls. his futures position starts showing losses.

Popular basic equity instruments/variables underlying options are: Index options Options on individual stocks. A purchases a call option from Mr. in a forward or futures contract. The holder does not have to exercise this right. it means Mr. In India stock options are American options. B of ABC ltd. STOCK OPTION: These options are options on individual stocks and a contract gives the holder to buy or sell shares at specific price. An option gives the holder of the option the right to do something. BUYER OF AN OPTION: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise the option contract. Jai Kumar Dungarwal Roll No. OPTIONS: Options are fundamentally different from forward and futures contracts. OPTIONS TERMINOLOGIES • • • INDEX OPTION: These options have stock index as the underlying.4. • WRITER OF AN OPTION: The writer of a call/put option is the one who receives premium and is thereby obliged to sell/buy asset if the buyer wishes to exercise his option. the two parties have committed themselves to doing something. In India index options are European. • AMERICAN OPTION: American options are options that can be exercised at any time upto the expiration date. Put options: As compared to call option put option gives the holder the right but not the obligation to sell an asset at a certain agreed period at a fix strike price. In contrast. index option contracts are also cash settled. Like index futures contracts. B gives the right to purchase ABC ltd at a fix strike price with agreed period. For example Mr. : 0190 Page 20 . Two basic types of options are: Call options: A call option gives the right but not obligation to buy underlying asset in a future date at a certain price.

We look here at the six basic payoffs. Jai Kumar Dungarwal Roll No. For a writer. (spot price>strike price) • AT THE MONEY OPTION: An at-the-money option is an option that would lead to zero cash flow if exercised immediately.• EUROPEAN OPTION: European options are options that can be exercised only on the date of expiry itself. These non-linear payoffs are fascinating as they lend themselves to be used to generate various payoffs by using combinations of options and the underlying. : 0190 Page 21 . (spot price=strike price) • OUT-OT-THE-MONEY OPTION: A call option is said to be out-of-the-money when the current spot price is lesser than strike price. His profits are limited to the option premium. however his losses are potentially unlimited. however the profits are potentially unlimited. • IN THE MONEY OPTION: A call option on the index is said to be in-the-money when the current market value is higher than strike price. the payoff is exactly the opposite. It is said to be at-the-money when current spot price is equal to strike price. In simple words. it means that the losses for the buyer of an option are limited.1 Options payoffs The optionality characteristic of options results in a non-linear payoff for options.( spot price<strike price) 4.

1. he loses. and buys it back at a future date at an unknown price S4 Once it is sold. Nifty for instance. he profits. the investor is said to be “short” the asset.1 Payoff profile of buyer of asset: Long asset In this basic position. an investor buys the underlying asset. and sells it at a future date at an unknown price. for 1220.S4 it is purchased. Figure B shows the payoff for a short position on the Nifty. Nifty for instance. If the index falls he loses.1 Figure A Payoff for investor who went Long Nifty at 1220 The figure shows the profits/losses from a long position on the index. If the index falls. for 1220.2 Payoff profile for seller of asset: Short asset In this basic position. Profit +60 0 1160 1220 1280 Nifty Loss -60 4. Figure A shows the payoff for a long position on the Nifty.1. Figure B Payoff for investor who went Short Nifty at 1220 The figure shows the profits/losses from a short position on the index. an investor shorts the underlying asset. The investor sold the index at 1220. 1 Source: NSE Derivatives Core Module Jai Kumar Dungarwal Roll No. If the index rises. If the index goes up. The investor bought the index at 1220. : 0190 Page 22 . the investor is said to be “long” the asset. he profits.4.

Figure C gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 1250 bought at a premium of 86. he lets his option expire un-exercised. Figure D gives the payoff for the writer of a Jai Kumar Dungarwal Roll No. 4.60. If upon expiration the spot price of the underlying is less than the strike price.1. the spot price exceeds the strike price. the spot price exceeds the strike price. Whatever is the buyer’s profit is the seller’s loss. If the spot price of the underlying is less than the strike price. Hence as the spot price increases the writer of the option starts making losses. For selling the option. If upon expiration.4 Payoff profile for writer of call options: Short call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Higher the spot price. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. he makes a profit. His loss in this case is the premium he paid for buying the option. If upon expiration. Higher the spot price more is the loss he makes.1. the buyer will exercise the option on the writer.3 Payoff profile for buyer of call options: Long call A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. the buyer lets his option expire unexercised and the writer gets to keep the premium.Profit +60 0 1160 1220 1280 Nifty -60 Loss 4. : 0190 Page 23 . more is the profit he makes.

His losses are limited to the extent of the premium he paid for buying the option.60 charged by him. The profits possible on this option are potentially unlimited. as the spot Nifty rises. Jai Kumar Dungarwal Roll No. If upon expiration.86. Figure C shows Payoff for buyer of call option The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option. the call option is in-the-money. Profit 1250 0 Nifty 86. the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price.three month call option (often referred to as short call) with a strike of 1250 sold at a premium of 86. However if Nifty falls below the strike of 1250. whereas the maximum profit is limited to the extent of the up-front option premium of Rs.60 Loss Figure D Payoff for writer of call option The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. If upon expiration. he lets the option expire. As can be seen. Nifty closes above the strike of 1250. : 0190 Page 24 . As the spot Nifty rises. the call option is in-the-money and the writer starts making losses. The loss that can be incurred by the writer of the option is potentially unlimited. the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. Nifty closes above the strike of 1250.60.

The profits possible on this option can be as high as the strike price. Lower the spot price. His losses are limited to the extent of the premium he paid for buying the option.1. he lets the option expire. As can be seen. If the spot price of the underlying is higher than the strike price. If upon expiration. Figure E gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 1250 bought at a premium of 61. the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. However if Nifty rises above the strike of 1250. he lets his option expire un-exercised. as the spot Nifty falls.60 1250 0 Nifty Loss 4.Profit 86. he makes a profit. the put option is in-the-money. If upon expiration.70. more is the profit he makes. Figure below shows Payoff for buyer of put option The figure below shows the profits/losses for the buyer of a three-month Nifty 1250 put option. His loss in this case is the premium he paid for buying the option. the spot price is below the strike price.5 Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. : 0190 Page 25 . Nifty closes below the strike of 1250. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Jai Kumar Dungarwal Roll No.

Profit 1250 0 Nifty 61.70 Loss 4. the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Niftyclose.61. Whatever is the buyer’s profit is the seller’s loss. If upon expiration. The loss that can be incurred by the writer of the option is a maximum extent of the strike price(Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs. the writer of the option charges a premium. As the spot Nifty falls. If upon expiration. Figure below shows Payoff for writer of put option The figure shows the profits/losses for the seller of a three-month Nifty 1250 put option. Below figure gives the payoff for the writer of a three-month put option (often referred to as short put) with a strike of 1250 sold at a premium of 61. For selling the option.70 charged by him. If upon expiration the spot price of the underlying is more than the strike price.1. : 0190 Page 26 . the spot price happens to be below the strike price. Jai Kumar Dungarwal Roll No.6 Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. Nifty closes below the strike of 1250. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. the buyer will exercise the option on the writer. the buyer lets his option expire un-exercised and the writer gets to keep the premium.70. the put option is in-the-money and the writer starts making losses .

Primary purpose of hedging is to reduce volatility thereby reducing the risk of a portfolio. Hedge ratio: It is defined as the number of contracts required to buy or sell so as to provide maximum reduction in the risk of portfolio. That loss must be sustained by the miller. The miller agrees to deliver the second lot of wheat at the time the flour is ready from market and at the price current at the time of the agreement. : 0190 Page 27 . In a simple example Mr.70 1250 0 Nifty Loss 5. which the miller does not presently own. options and swaps are widely used as a tool for hedging. the miller will contract to sell an equal amount of wheat. HEDGING Hedging is a mechanism to reduce the risk or minimize losses that are inherent in open positions. higher price. ABC buys wheat which is to be converted in to flour. Derivatives like futures. Hedging does not mean maximization of profits/returns but it only means reduction in variation of return. (called Beta) Jai Kumar Dungarwal Roll No. At the same time. the miller makes up for this loss on the flour sale by the gain on the wheat sales. Hedge can help lock in existing profits. This depends on : Value of futures contract. to another trader. If the price of wheat declines during the period between the miller’s purchase of the grain and the flour’s entrance onto the market. Sensitivity of the movement of portfolio with that of the index.Profit 61. However. since the miller has a contract to sell wheat at the older. there will also be a resulting drop in the price of flour.

Various terms under hedging are: Long Hedge: Long hedge is a transaction when we hedge our position in cash market by going long in derivatives markets. then in order to protect our portfolio we can go short in the derivative market. are not available. Let us make a hypothetical case study under certain assumptions for more clear view of utilizing futures as a hedging tool: Jai Kumar Dungarwal Roll No. Equity derivatives are the financial derivatives whose values are derived from underlying securities. that are available. Hedger enters the futures market in order to protect himself from the risk of an adverse price movement. Futures and Options are the most common type of equity derivatives and are used as an effective tool for hedging. HEDGING WITH FUTURES: Buying stock futures contract is similar to that of buying number of shares for number of underlying stock but without taking delivery for the same. It does not necessarily lead to a better outcome. This is called cross hedge. 6. For example let us assume that we are going to receive funds in the near future and we are bullish about the market but we are required to invest more money which is not desirable. Risk appetite of the investor. These are primarily based on various underlying stocks and stock indices and performance are closely linked with the underlying securities. Cross hedge: when derivatives of the underlying assets that we have. For example prices of the stocks which we have invested are continuously going down or are highly volatile. Hedging only makes an outcome more certain. we use some other related underlying. Although hedger may be bullish about the market still he may have some fear about the negative movement in the market. : 0190 Page 28 .Portfolio to be hedged. If the hedger wants to increase value of his portfolio or if he wants to maintain same value for his portfolio which consists of variety of blue chip stocks he may consider selling the futures or purchasing it as the case may be in the market. The risk can be hedged by investing in Futures & options of derivatives market Short Hedge: It is a transaction accomplished by going short in the derivatives market.

So what is the fun investing if the portfolio is not giving any good returns. Second Scenario:With the same amount of above mentioned investment say your Beta is 1. 6 lots of Nifty Futures of Rs 150. your equity portfolio would be worth Rs 810.. your total margin requirement say approximately Rs 210. Over the next two weeks.000 in futures. Rs 1.000 each. Say the market moves up five percent from 4000 in a day.000 while 6 lots of 50 Nifty each will fetch you Rs 90. we require Rs 900.e. To hedge Rs 900. So instead going short of 6 lots go short for 7 lots to protect the downside risk of the investor and what if the market moves up at the same point of time.000 plus Rs210. Following are the assumptions for hedging the portfolio Assumptions:  Futures are purchased in a lot size of 50. Two types of scenario that are taken in to account are: 1.25 of the portfolio which includes various aggressive and non-aggressive stocks.Mr. Your mark to market losses would be 150x50x6 = 4500. Simple hedging which has beta of 1 2.  10% margin is required to be paid while entering in to futures contract.e.000 as shorting futures has more margin requirements as compared to that of going long in the futures market.000 (6 x 50 x 300).000 of equity portfolio.000. no loss. Jai Kumar Dungarwal Roll No. Now that’s a simple hedge in futures. i.020. Your portfolio is now worth Rs 810. the nifty grinds down to 2700. So that is where you deploy your surplus cash. that is a small price to pay. ABC has a portfolio of 9 lakhs and 1 lakh is invested in cash market which is in various blue chip companies in nifty index. If you short these 6 lots at Nifty 3000. The same amount that your portfolio would gain.  Valuations of the portfolio should not be shrinked.a small fall in profit. : 0190 Page 29 . No profit. First Scenario:Say your equity portfolio has a beta of 1 and the Nifty is at 3500. Thus the concept of a stop loss can be used.  As per the risk appetite of the investor he would be hedging his portfolio. despite a 10% fall in market. Your decision dilemma is . Hedging for new investors which has beta of more than 1 In the bullish market although investor wants to stick out with his portfolio for two years but he may still have some fear as it is not possible that his each invested stock would rise and hence he enters in to contract to protect his portfolio. 000 i. say at 3% above the market price.should I sell or buy more to average out? No its better to opt for hedging your portfolio against the market movements. In the current market conditions. So in the event the Nifty tanks to 2700. So the downside is fully protected but the cost is .

He will sell the stock or 2. The best way to save your money is by keeping your portfolio hedged. Although investment in the equities are and should be for a long term horizon there are time in the markets when it deeps to extremely low levels. 7. Remain invested and bear the brunt of volatility.Another variation to the strategy . Two simple techniques of using derivatives to deal with range bound or volatile markets are call option and put options which are explained above. : 0190 Page 30 . This essentially means that you sell index futures of the amount of the portfolio you have taking into consideration the beta of your portfolio. book your profit in a lot or two and use the cash to buy your favorite stock. Buying a put option is the best strategy for the retail investors to hedge their portfolio against downside risk. The simplest way to hedge your portfolio is by selling index futures. it immediately reacts with the trend of the market. The third possible way to protect his portfolio can be over longer time of frame. It also depends on the risk appetite of the investor how much he wants to hedge his position in the market from the value of his portfolio. Now option contracts are not only available for hedging risk against fluctuations of the market but also to increase the value of their portfolios and take opportunity of variety of investments available. he can use options. In such volatile market conditions investor has two of the possibility availed: 1. As every portfolio is linked with some risk. Jai Kumar Dungarwal Roll No. The capital gains in a year or so is wiped off in a week or so.if over a period of time the equity portfolio value falls substantially ( and that seems to be the case for most of us!) and you find yourself over hedged. In recent months due to various reasons we have seen volatility at its best. Assuming portfolio in line with NIFTY the ideal combination is one lot for every two lakhs of investment. A key question that might arise is how many NIFTY puts or calls one should buy or short. HEDGING USING OPTIONS: The only thing that is certain about the market is uncertainty. As compared to same call option can again be used as strategy if the investor is bullish about the market but again he has to protect himself against downside risk so he can use both combinations to increase the value of portfolio or hedge himself against the market volatility.

1 STRATEGIES UNDER OPTIONS 7. As the contract becomes more profitable. Alternatively there might even be instances where the hedged position incurs a loss. One should avoid the temptation to try and hedge 100% possible draw down in portfolio as this would mean incurring higher cost. Below given are some of the tools and strategies that can be used in the bullish market by the new investors as well as current players having their portfolios. the more out-of-the-money the call is the more bullish the strategy. In general. As he is bullish about the market he decides to purchase 100 units of Jai Kumar Dungarwal Roll No. as the strategy has upside potential with limited downside risk. It is used by aggressive investors who are very bullish about the prospects of the stock/index. The primary motivation for such an investor is to realize financial reward from an increase in price of the underlying security. BENEFIT: A long call option offers a leveraged alternative to a positioning the stock. REWARD: Profit that can be earned is unlimited.1.Hedging should not be considered as a tool for making money. as bigger increases in the underlying stock price are required for the option to reach the break-even point. Long call contracts offer the investor a pre-determined risk. Let’s say NIFTY is trading at 3600. EXAMPLE: Mr. 2009 who is new in the market and wants to make fresh investment but is not ready to take risk with his new investment.1 LONG CALL: Although long call is not a pure hedging strategy it can be used as one of the tool for hedging. sometimes even 10 to 20% of portfolio value and may result in heavy loss if the market does not move down as expected. increasing leverage can result in large percentage profits because purchasing calls generally requires lower investment of capital as compared to purchase of underlying stock. RISK: Risk is limited to the amount of premium paid for purchasing number of unit of shares which is downside risk. : 0190 Page 31 . Thus he is ready to take the risk but only to the extent of Rs. The best it can achieve is minimizing the risk. ABC is bullish about the market as on 8th May. 7. Buying a call is the most basic of all options strategies.5000 as explained in the below example.

Jai Kumar Dungarwal Roll No. Thus it is a strategy with a limited loss and unlimited profit which is arrived at after deducting the put premium and from the stock rise respectively. In case price of the stock falls. Thus it can be summarized as: Strike price: 3800 Premium paid: 100*50=5000 Break Even Point: (Strike price + Premium) 3800+50=3850 Per Unit. As price of the stock decreases he can minimize the loss by adopting put option. The payoff for the same can made as follows: Nifty on expiry 3600 3700 3800 3850 4000 4100 4200 Payoff from option (Rs. ABC would start earning profits and if market goes against the expectations of the investor he may not exercise the option and thus his loss would be limited to the extent of amount of premium paid but the profits earned can be unlimited.CA NIFTY options for the strike price of 3800 by paying the premium of Rs.50 for the same.2 SYNTHETIC LONG CALL: This investment strategy is used when an investor is desired to have a stock for the long run yet investor is concerned about the short term downside risk of the stock.) -50 -50 -50 0 150 250 350 7. BENEFIT: In case the price of the stock rises he can reap the benefit from the stock which he has purchased from the cash market. exercise the put option.1. contract of which expires on 30th June. Now to insure against short term downside risk he will purchase a put option of the stock which gives him right to sell the stock at the strike price which can be price at which you bought or slightly below then strike price. Thus we can say that as and when market surpasses 3850 mark Mr. : 0190 Page 32 . As we are bullish about the stock in the long run investor will purchase underlying stock from the cash market.

RISK: It is only to the extent of premium paid for the put option for the near term downside risk.75. : 0190 Payoff from the option +125 +75 0 -75 -75 25 Page 33 .1775 (Rs. 1900 in the cash market. EXAMPLE: Mr. Amount is deducted from the strike price as it is a put option which gives right to sell the stock. He is having RIL which is currently trading at Rs. ABC who is having a portfolio of Rs.1850-Rs75 premium paid). REWARD: In case the stock price rises then investor can earn unlimited profits as he is having underlying stock and in case if the stock price falls then he can earn profits by exercising the put option which gives him the right to sell the stock. The payoff chart can be made as follows: RIL prices 1650 1700 1775 1850 1900 2000 Jai Kumar Dungarwal Roll No.75 Break Even Point: Rs.1850 by paying the premium of Rs. it can summarized as follows: Strike price: 1850 at premium of Rs. In order to protect against downside risk he purchases put option for the same stock for strike price of Rs. Thus we can say that this strategy can be utilized when investor wants to earn in the long run as well as to minimize losses against the fall in the price of the stock.10 lakhs and is bullish about the market but in order to protect himself against the downside risk uses this strategy to protect the value of his portfolio.

Breakeven point from the point of view of buyer will come as and when price goes beyond premium. EXAMPLE: Mr. 1800 Premium received: Rs. Thus we can say that this strategy can be adopted by the investors in the range bound or rising markets to earn short term profits from the stock but investor has to be meticulous while selecting the stock as downside risk involved in the same is very high. ABC is bullish about the market and is positive about RIL stock which is currently trading at Rs.60. It can be summarized as: Strike price: Rs.1900 in the market.1740 (1800-60) from the view point of the buyer. This strategy can be used as a hedging tool by the new investors in the market. the short put position will make profit for the seller of the put option as the buyer of the option is not going to exercise the put option and premium amount is retained by the seller of the put option. If the stock price increases beyond the strike price and as it is a put option.60 Breakeven Point: Rs. : 0190 Net payoff from the option 60 60 0 -40 -90 -140 Page 34 .7. BENEFIT: As and when you sell the put you earn a premium from the buyer of the put option. REWARD: Potential loss is very high and reward is limited to the price of the premium of the put option. RISK If the stock price reduces beyond the strike price and gets reduced by amount of premium then buyer of the put option will start making the profit and hence downside risk involved for seller of the put option is very high. Net payoff is as follows RIL prices 1900 1850 1840 1800 1750 1700 Jai Kumar Dungarwal Roll No.3 SHORT PUT: This strategy can be used by investors when he is bullish about the market – expects the stock price to rise or stay sideways at the minimum. He sells the put option at a strike price of 1800 for a premium of Rs.1. The primary motive is to earn short term income by selling the put option.

700 OTM – higher strike price for call option Premium paid: Rs. EXAMPLE: Mr. Hence by adopting this strategy he sells a put option with a strike price of 500 at a premium of Rs.700 for call option + Rs.10. This strategy is adopted when the investor is bullish about the market and expects the stock price to rise in the future but does not want to make higher investment in the stock. it can be summarized as follows: Strike price: Rs.60.500 OTM higher strike price for put option Premium received: Rs. REWARD: Investor can make the money as and when price of the stock goes beyond the net premium and reward is unlimited to the extent of the increase in the price of the stock.7. RISK: When put option is sold downside risk increases as price goes beyond strike price and beyond premium and as he buys a call option risk is limited only to the price of the premium paid if the price does not go beyond the strike price.4 LONG COMBO: SELL A PUT.60 Breakeven Point: Rs. : 0190 Page 35 . But he does not want to make investment of 600. 50 and buys a call option with a call option of Rs.50 Strike price: Rs. Otherwise Jai Kumar Dungarwal Roll No. Hence net cost for the strategy would be Rs.10 net premium investment) Thus we can say that this strategy can be used when investors wants to make less investment and is bullish about the market and can earn huge profits but only if the stock moves up. BUY A CALL: The long combo is variation of a long synthetic future. BENEFIT: As the strategy involves selling over the money put option and buying higher strike call as he is bullish about the market investor will start making the money when it goes above the strike price and net premium investor will start getting benefit from the investment.600 in the cash market. ABC is bullish about ICICI which is currently trading at Rs. The only difference in this strategy is that we sell Over The Money (OTM) puts and buy OTM higher strike call.700 at a premium of Rs.710 (Rs.1.

In such cases. It’s attractive to sell an Over the Money or At the Money call while you already own the stock. So maximum risk is the difference between price at which stock is purchased and premium received against call option. RISK: Downside risk involved is in this strategy is very low as compared to other strategies as investor purchases the shares of the company. Here he can be benefited in a manner that he already owns the stock of the company and can sell if the price rises beyond the call option. The net payoff by adopting this strategy can be calculated as follows: ICICI price 850 800 750 710 650 600 550 500 450 Net payoff from put sold 50 50 50 50 50 50 50 50 0 Net payoff from call option 90 40 -10 -60 -60 -60 -60 -60 -60 Net payoff 140 90 40 -10 -10 -10 -10 -10 -60 7. BENEFIT: As investor already owns the shares of the company and sells an OTM call option he can earn premium as part of benefit from the strategy.5 COVERED CALL: The covered call is a strategy adopted by the investor when he is neutral or moderately bullish about certain stock which he holds but not much in a near term and still wants to earn income from the shares.1. In this strategy investor sells a call option on a stock he owns and earns a premium on it. Since the stock is purchased simultaneously with writing (selling) the call. meaning you’ll end up delivering the stock at the strike price of the sold call. The option would be exercised by the purchaser of the call if the price level goes beyond sum of strike price and premium. the premium you collect will he higher as will the likelihood of exercise. the strategy is commonly referred as “buy-write”. But if the stock price goes against the expectations of investor he will lose the entire value of the stock except the premium received for the call option. : 0190 Page 36 .potential losses can be very high in this strategy. Jai Kumar Dungarwal Roll No.

100 (800-700). EXAMPLE: Mr. It can be summarized as follows: Purchase price of stock: Rs.800 then he makes profit of Rs.760 and if goes beyond that then he has make the payment of the price which goes beyond 760. Mr. But against that he will exercise the stock which he has purchased from the cash market for Rs.100 paid for exercising the call option = Rs. The net payoff can be calculated as follows: ICICI Stock price 450 500 540 600 800 Jai Kumar Dungarwal Roll No. ABC who is new investor wants to invest in the market and is bullish about the market purchases the stock ICICI for 600 but as he wants to protect himself against the downside risk he simultaneously sells the call option for Rs 700 for premium of Rs. It can be explained as follows: As buyer of the option will exercise option.60 Breakeven point: Rs.700 Premium received: Rs.200 Profit made by selling security + Rs.600 and hence if the stock price reaches Rs. Call option would be exercised only if it goes beyond Rs.60.540 (600-60) Now if the price reaches to 800 still investor can make profits. Therefore net investment becomes 540 for Mr. 200 (800-600).700 then Mr. ABC can retain the premium earned against the call option. But again he can make profits from the stock which he has already purchased from the cash market.600 Strike price: Rs. ABC.REWARD: Benefit under this strategy is limited to the extent of difference of call strike price and stock price paid for purchasing the stock and premium received against sell of call option. : 0190 Net payoff -90 -40 0 60 160 Page 37 . If the stock price stays beyond Rs.160 profit.60 premium received by selling a call option – Rs. ABC has to pay him difference between strike price and rise in price that is Rs. Thus net effect would be Rs.

900 and put option for strike price of 3.80 for call option and Rs. The strategy involves in purchasing call option as well as selling put option for the same maturity and strike price to take advantage of a certain volatile market. Premium paid: Rs. ABC who is having a portfolio Rs.80 and Rs. If the market does not reach either upward limit of 3980 or downward limit of 3610 Mr.7. call and put.900 for call option and 3700 for put option. EXAMPLE: Mr. Breakeven point: Rs.e. The net payoff for the same can be calculated as below: Jai Kumar Dungarwal Roll No. RISK: Downside risk involved in such strategy is limited to the price of premium purchased for both types of option i. : 0190 Page 38 . REWARD: Reward is unlimited as soon as the price crosses the strike price in either of the options. ABC would not exercise the option and would have loss to the extent of premium paid that is of Rs. Thus this strategy can be opted when investor is expecting higher movements in the market.3610 for put option. it may be bear market or bull market.10 lakhs and expects markets to move either side and wants to hedge himself in the market he purchases nifty futures which are currently trading at 3. The option would be exercised if an option crosses the price of premium paid for it.90 for put option.1. Hence it can be summarized as: Strike price: 3.90 respectively.6 LONG STRADDLE A straddle is basically a volatility strategy and it can be used by investors when certain stocks are showing high volatility of large sideways movements. In case the market goes up investor would exercise the option if it reaches beyond 3980 and in case market falls he will exercise option if market falls below 2610.170 in the above case.800 and purchases call option for a strike price of 3. BENEFIT: As strategy involves purchasing call option as well as shorting put option at certain strike price to be exercised on the same date an investor can be benefited through this strategy in both types of market.700 for premium of Rs.3980 (strike price + premium paid) for call option and Rs.

Hence benefit involved in this strategy is limited since the put prevents the downside risk and selling a call option prevents that risk. RISK: Risk is very limited in this strategy as investor gets covered by purchasing a put option against a stock and selling a call which protects him from downside risk. Generally in this strategy put option is ATM and call option is OTM.1. Although investor is neutral to bullish still he wants to earn the income and hence can use this strategy. REWARD: Reward is very limited in this strategy as this strategy involves a very low risk taken by the investor. BENEFIT: Collar strategy is buying a particular stock and the same is insured against the downside by buying a put and selling a call.30 premium for put option. Hence this strategy is adopted when the investor is conservatively bullish. It can be summarized as: Jai Kumar Dungarwal Roll No.30 premium. This strategy can be used by new investors as well as to hedge the existing portfolio of the investor. EXAMPLE: Mr. ABC holds the stock of XYZ ltd. : 0190 Page 39 .On expiration price of nifty futures 4200 4100 4000 3980 3800 3700 3610 3500 3400 3300 Payoff from call option 220 120 20 0 -80 -80 -80 -80 -80 -80 Payoff from put option -90 -90 -90 -90 -90 -90 0 110 210 310 Net payoff 130 30 -70 -90 -170 -170 80 30 130 230 7. 40 for call option and Rs. Only addition in collar strategy is it involves purchasing of another put option and hence it is a covered call with limited risk.40 premium and purchasing put option 3500 for Rs. ABC would be 3590 as he receives Rs.7 COLLAR: A collar strategy is similar to that of covered call where investor is neutral to moderately bullish about the market. which is currently trading at 3600 and he decides to adopt collar strategy by writing a call of 3800 for Rs. Here the net investment would be for Mr.

This strategy can be utilized by the new investors where although he is bullish about the market as strategy brings down investment and can hedge him against the downside risk in the market with limited investment. Hence this strategy effectively deals with purchasing and selling call options and can be used by investor when he is moderately bullish to bullish about the market.1. Jai Kumar Dungarwal Roll No. : 0190 Page 40 . Premium: Rs.3590 (purchase price of stock + premium for call – premium for put) In case market moves up as investor has sold call option then he has to pay to the seller of the call option but can earn the profits by selling the underlying stock. Maximum loss occurs where the underlying falls to the level of the lower strike or below.8 BULL CALL SPREAD STRATEGY: This strategy is adopted by the investor when he wants to bring down the cost and breakeven on a buy call (Long call) strategy by creating a spread by purchasing in-the-money (ITM) call option and selling out-of-the-money (OTM) call option. RISK: The risk involved in this strategy is limited to the extent of premium paid for establishing the positions in the market.40 for writing call option and Rs. The biggest benefit that an investor gets by this strategy is he can bring down his cost of investment and still can earn huge profits with limited downside risk. Hence he can earn two ways income from put option as well as premium received against writing the call option. Breakeven point: Rs.30 for put option. BENEFIT: Investor can be benefited if the market moves as per his expectations and will make profit when the market rises. In case the market starts coming down then he gets protected against downside movement of the market by exercising the put option after it goes above the strike price. Hence the net payoff can be explained as below: Closing price of XYZ ltd 3300 3400 3500 3600 3700 3800 3900 Payoff from call sold 40 40 40 40 40 40 -60 Payoff from put purchased 170 70 -30 -30 -30 -30 -30 Payoff from underlying stock -300 -200 -100 0 100 200 300 Net payoff -90 -90 -90 10 110 210 210 7.Strike price: 3800 for writing a call and 3500 for put option.

buying two at-themoney Calls and selling another higher strike out-of-the-money Call. Hence his net investment would be Rs.e. difference between two premiums. Premium: Rs. He can make the profits as soon as investment crosses the breakeven point. giving the investor a net credit (therefore it is an income strategy). The net payoff chart can be prepared as follows: Closing price of Nifty on expiry Net payoff from call option Net payoff from written call option Net payoff 2800 2900 3000 3100 3200 3300 3400 -100 -100 0 100 200 300 400 60 60 60 60 60 -40 -140 -40 -40 60 160 260 260 260 7.60 OTM writing call option.1.40 i. he writes the call option of 3200 for premium of Rs. ABC purchases nifty call which is currently trading at 3000 and purchases call of 2900 by paying premium of Rs. It is just opposite of long call butterfly strategy. Jai Kumar Dungarwal Roll No.2900 for purchasing call and Rs. There should be equal distance between each strike. However strategy also has limited gains and hence is ideal for investor when he is moderately bullish to bullish about the market.9 SHORT CALL BUTTERFLY: This is a strategy that can be generated in the range bound and volatile markets. Breakeven Point: 2900 + 40 = 2940 (strike price of purchased call + net premium) Hence we can say that this strategy can be applied to reduce the investment and can be helpful for new investors in the market. It can be summarized as: Strike price: Rs.3200 for writing a call option. : 0190 Page 41 .100. 60.100 for ITM call option and Rs.REWARD: Maximum profit is limited to difference between the two strike prices less the net debit premium paid for call options. The Short Call Butterfly can be constructed by Selling one lower striking in-the-money Call. This strategy should be used when investor is neutral on market conditions and bullish on volatility of the stock. EXAMPLE: Mr.

1000 for 2 call options purchased. it can be summarized as follows: Strike price: Rs. 70 premium. Breakeven point: Upper breakeven point is 1270 and lower breakeven point would be 930. EXAMPLE: This strategy purchasing 2 ATM call option. sell 1 ITM call option and 1 OTM call option. this strategy offers very small returns when compared to straddles. REWARD: The maximum profit occurs if the stock finishes on either side of the upper and lower strike prices at expiration. However. Mr. Hence we can say that by using this strategy can be used by such an investor who is feared about the market and wants to minimize the losses of his portfolio by making less investment and limited downside risk as well as profit. Thus net credit would be Rs. 60 per option. The net payoff can be calculated as below: Jai Kumar Dungarwal Roll No. strangles with only slightly less risk. sells call option of 900 for 80 premiums and sells 1300 strike price call option for Rs.30.BENEFIT: As the strategy involves selling and purchasing of call options it gives the investor a benefit of premium that can be received by writing of the call options of various strike price involved. ABC purchases 2 ATM call option which is currently trading at Rs.120 for purchasing call option and Rs. 900 for ITM option & 1300 for OTM option. This strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and collect an income. RISK: The maximum risk involved in this strategy is to the extent of difference between the strike prices less net credit received for variety of call options purchased and sold at different strike price.1000 for which he pays a premium of Rs. : 0190 Page 42 . The maximum risk occurs if the stock / index is at the middle strike at expiration. 150 for selling call options. Premium: Rs.

National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003.Price on expiry 700 800 900 1000 1100 1200 1300 1400 1500 Payoff from 2 purchase call option -120 -120 -120 -120 -20 160 360 560 760 Payoff from ITM sold call option 80 80 80 -20 -120 -220 -320 -420 -520 Payoff from OTM sold call option 70 70 70 70 70 70 70 -70 -170 Net payoff 30 30 30 -70 -70 10 110 70 70 8. 11 May 1998 L.C. DERIVATIVES IN INDIA The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges.C. Chronology of instruments 1991 Liberalization process initiated 14 December 1995 NSE asked SEBI for permission to trade index futures. Below is the chronology of the instrument which discloses the various steps for development of derivatives in India. 18 November 1996 SEBI setup L. : 0190 Page 43 . to provide a platform for commodities trading. NSE and BSE.Gupta Committee to draft a policy framework for Index futures.Gupta Committee submitted report. Jai Kumar Dungarwal Roll No. There are various contracts currently traded on these exchanges.

: 0190 Page 44 . 9 June 2000 Trading of BSE Sensex futures commenced at BSE. 24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian Index. After revolutionary changes of 1990’s . coupled with the wide spread knowledge and orientation towards equity investment and speculation.7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) Interest rate swaps. have combined to provide an environment where the equity spot market is now India’s most sophisticated financial market. Individual Stock Options & Derivatives Trading at Stock Options at NSE 9th July 2001 Stock Options launched at BSE 1st Nov 2001 Stock futures launched at BSE Dec 2006 1st Oct 2008 Derivative exchange of the year by Asia risk magazine Currency Derivatives introduced (currency futures on US Dollar) Feb 2010 Launch of Currency future on additional currency pairs at NSE Apr 2010 Financial Derivatives exchange award of the year by Asian Banker to NSE 30th March 2012 Launched BRICSMART indices derivatives 8. Jai Kumar Dungarwal Roll No. 12 June 2000 Trading of Nifty futures commenced at NSE. 25 September 2000 2 June 2001 July 2001 Nifty futures trading commenced at SGX. 25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.1 EQUITY DERIVATIVES IN INDIA:The opening of Indian economy has precipitated the process of integration of India’s financial markets with the international financial markets. the new institutional arrangements. One aspect of the sophistication of the equity market is seen in the levels of market liquidity that are now visible.

byelaws. and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. of contracts Turnover (Rs. Single stock futures were launched on November 9. : 0190 Page 45 . 2001.The trading in BSE Sensex options commenced on June 2. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12. Futures contracts on individual stocks were launched in November 2001. 2001. cr. 2001 and trading in options on individual securities commenced on July 2. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules. 2000. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.) 2005-06 58537886 1513755 2006-07 81487424 2539574 2007-08 156598579 3820667 2008-09 210428103 3570111 2009-10 178306889 3934388 2010-11 165023653 4356755 2011-12 146188740 3577998 2012-13 96100385 2527131 2013-14 105252983 3083103 2014-15 125977607 4019431 Source: NSE website Jai Kumar Dungarwal Roll No. Growth of equity derivatives with reference to futures and options in India is as shown in the below chart and diagram: Total Year No. 2001 and the trading in options on individual securities commenced in July 2001. The trading in index options commenced on June 4.

If we compare the trading figures of NSE and BSE.000.000 2. the situation at BSE is just the opposite: its cash segment outperforms the derivatives segment. The introduction of derivatives has been well received by stock market players. Introduced in 2000.000 1.000 1. : 0190 Page 46 . the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market.000 - 50.500. the value of the NSE derivatives markets was Rs.038 Cr. of contracts Turnover (Rs.477.000.000. An important feature of the derivative segment of NSE which may be observed is the huge gap between average daily transactions of its derivatives segment and cash segment.000 4.) Thus the graph clearly indicates the way equity derivatives that is individual futures and options as well as index options and futures that have exponentially grown in the country and more awareness among the investors.500.000.000.500.000 3.000. 90. In case of BSE.000.250.000 - Years No.000 Turnover in Crores No. of contracts 5. In sharp contrast to NSE.000 150.000. single stock futures also known as equity futures. Jai Kumar Dungarwal Roll No.000 4. Among all the products traded on NSE in F& O segment. followed by index futures with turnover shares of 52 percent and 31 percent. in 2008.51. whereas the value of the NSE cash markets was only Rs. In due course. 1) and is expected to continue the same in the years to come. For example.000 500.000. index futures outperform stock futures.000 100. respectively.500.000 3.000. cr.000 200.75 Cr. performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories. are most popular in terms of volumes and number of contract traded. financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. 35.000 2. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. Growth of Derivatives Market in India Equity derivatives market in India has registered an "explosive growth" (see Fig. 130. Trading in derivatives gained popularity soon after its introduction.

Figure 1: Business Growth of Derivatives at NSE from 2000-2009 Source: NSE fact book 2008 issue Jai Kumar Dungarwal Roll No. : 0190 Page 47 .

The following is a tabular representation of the turnover of different segments in the
derivatives market:
Business Growth in Derivatives segment

Year

Index Futures
No. of
contracts

2014-15
2013-14
2012-13
2011-12
2010-11
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01

Stock Futures

Turnover (Cr.)

No. of
contracts

Index Options

Turnover (Cr.)

Stock Options

No. of
contracts

Turnover (Cr.)

No. of
contracts

Turnover (Cr.)

21866521

781940.72

48415080

1789643.7

158734718

5696734.03

17604910

666655.38

105270529

3085296.5

170414186

4949281.7

928565175

27767341.2

80174431

2409488.6

96100385

2527130.8

147711691

4223872

820877149

22781574.1

66778193

2000427.3

146188740

3577998.4

158344617

4074670.7

864017736

22720031.6

36494371

977031.13

165023653

4356754.5

186041459

5495756.7

650638557

18365365.8

32508393

1030344.2

178306889

3934388.7

145591240

5195246.6

341379523

8027964.2

14016270

506065.18

210428103

3570111.4

221577980

3479642.1

212088444

3731501.84

13295970

229226.81

156598579

3820667.3

203587952

7548563.2

55366038

1362110.88

9460631

359136.55

81487424

2539574

104955401

3830967

25157438

791906

5283310

193795

58537886

1513755

80905493

2791697

12935116

338469

5240776

180253

21635449

772147

47043066

1484056

3293558

121943

5045112

168836

17191668

554446

32368842

1305939

1732414

52816

5583071

217207

2126763

43952

10676843

286533

442241

9246

3523062

100131

1025588

21483

1957856

51515

175900

3765

1037529

25163

90580

2365

-

-

-

-

-

-

Source: NSE fact book 2014 issue

8.2 OPERATORS OF DERIVATIVES MARKET
Broadly operators of derivatives are divided in three categories i.e. arbitrageurs, hedgers and
speculators. 
Arbitragers: They are operators who are involved in business to take advantage of
differential pricing in two different markets. If, for instance they see the future price of an
asset getting out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit.

Jai Kumar Dungarwal
Roll No. : 0190

Page 48

 Hedgers: They are the operators who want to transfer a risk component in their portfolio
by minimizing losses. They are mainly engaged in futures & options market to minimize
their risk and thereby minimizing losses.
Take an example: A Hedger pay more to the farmer or dealer of a produce if its prices
go up. For protection against higher prices of the produce, he hedges the risk exposure by
buying enough future contracts of the produce to cover the amount of produce he expects
to buy. Since cash and futures prices do tend to move in tandem, the futures position will
profit if the price of the produce raise enough to offset cash loss on the produce. 

Speculators: They are basically engaged in speculating or betting future price

movements of the asset. Futures and options contracts give them extra leverage and they
may earn huge profits and probability of potential losses is also higher. They are the
second major group of futures players. These participants include independent floor
traders and investors. They handle trades for their personal clients or brokerage firms.
Buying a futures contract in anticipation of price increases is known as ‘going long’.
Selling a futures contract in anticipation of a price decrease is known as ‘going short’.

8.3 REGULATION OF DERIVATIVES TRADING IN INDIA
The regulatory framework in India is based on L.C. Gupta committee report and J.C. Varma
committee report. It is most consistent with the International Organization of Securities
Commission (IUSCO). The L.C. Gupta committee report provides a perspective on division of
regulatory responsibility between the exchange and SEBI. It recommends that SEBI’s role
should be restricted to approving rules, bye laws and regulations of a derivatives exchange as to
approving the proposed derivatives contracts before commencement of their trading. It
emphasizes the supervisory and advisory role of SEBI. It also suggests establishment of a
separate clearing corporation.

8.4 INDIAN DERIVATIVES VIS-À-VIS GLOBAL
DERIVATIVES:
The derivative segment has expanded in the recent years in substantial way both globally as well
as in the Indian capital market. The Indian segment has grown phenomenally as compared to the
global segment. The Notional value of NSE option was 354648.91 lakhs USD and the number of
contracts were 67458468 and the notional value at NSE futures was 39228.38563 lakh USD and
the number of contracts were 7815624 in 2013 which are much more than it was in preceding
years.

Jai Kumar Dungarwal
Roll No. : 0190

Page 49

Though the derivatives market in India is nascent as compared to the U.S. and European markets,
yet the pace with which it is growing is far more as compared to its counterparts and thus the
future prospects of the Indian derivatives market is bright.

Jai Kumar Dungarwal
Roll No. : 0190

Page 50

QUESTIONNAIRE ST. : 0190 b) No c) Can’t say Page 51 .S.9. market? a) Yes Jai Kumar Dungarwal Roll No. XAVIER’S COLLEGE DERIVATIVES – THE GLOBAL CASINO Name --- 1) Are you aware about the Meaning of Derivatives? a) Yes b) No 2) Are you trading in the Derivative market? a) Yes b) No 3) If not. reasons for not investing in the derivatives market? a) Lack of Knowledge b) Very Risky c) Huge amount of investment d) Other 4) Which of the following Derivatives instrument have you heard about? a) Stock Futures b) Stock index futures c) Stock options d) Stock index options e) Swaps f) Currency g) None 5) Do you think the Indian Derivative market is matured enough as compared to the U.

6) Are necessary steps being taken to make people aware about the Derivatives market? a) Hedger b) No 7) Do you think that awareness programmes about Derivatives should be initiated at college level? a) Yes Jai Kumar Dungarwal Roll No. : 0190 b) No Page 52 .

only about 75% were totally sure of what a derivative actually is. Thus. even though in accounting and finance. ANALYSIS 1) Are you aware about the Meaning of Derivatives? a) Yes b) No 40% 60% Aware Unaware Comment: Of the survey taken around 40% of the respondents were unaware of derivatives. Out of the 60%. 40% are yet to know about derivatives and its use.10.. Jai Kumar Dungarwal Roll No. : 0190 Page 53 .

Jai Kumar Dungarwal Roll No. a vast majority of them do not trade in the market.33% No Comment: Almost a negligible le percentage of the respondent respondents trade in the Derivatives market. market When further questioned.2) Are you trading in the Derivative market? a) Yes b) No 6. : 0190 Page 54 .67% Yes 93. A reason could be unawareness about this market and therefore risk averseness is natural.

Jai Kumar Dungarwal Roll No.3) If not. Also people believe that it is very risky and thus often link derivatives trading to gambling. : 0190 Page 55 . Some of the respondents who were aware said that huge amount of investment is required for trading in the derivatives market which is evident from the fact that futures and wide variety of options are standardized contracts and thus requires trading in lot lots. reasons for not investing in the derivatives market? a) Lack of Knowledge b) Very Risky c) Huge amount of investment d) Other 60% 50% 40% 30% 20% 10% 0% Lack of Knowledge Very Risky Huge Amount of Investment Other Comment: A vast majority do not trade in the derivatives market because of lack of knowledge.

Jai Kumar Dungarwal Roll No.4) Which of the following Derivatives instrument have you heard about? a) Stock Futures b) Stock index futures c) Stock options d) Stock index options e) Swaps f) Currency g) None 30% 25% 20% 15% 10% 5% 0% Comment: Stock futures emerged as the most popular as compared to the other instruments followed by Stock Options and then followed by the others. : 0190 Page 56 . none among the respondents had heard about Currency derivatives in practice. Surprisingly.

derivative market.S.S. 20% believed the Indian Derivative market to be at par with the U. market while 30% said that Indian Derivative market is not as matured as the U. Clearly it reflects on the unawareness of this market among the respondents.5) Do you think the Indian Derivative market is matured enough as compared to the U. market? a) Yes b) No c) Can’t say 20% Yes No 50% 30% Can't say Comment: Half the respondents were not aware about the status of the Indian Derivatives Market and thus could not answer this question. Jai Kumar Dungarwal Roll No. : 0190 Page 57 .S.

A lot of wealth is amassed by few people aware about Derivatives and who frequently trade in the derivatives market and get a handsome return. need arises for making people informed about derivatives. Thus. Jai Kumar Dungarwal Roll No. : 0190 Page 58 .6) Are necessary steps being taken to mak make e people aware about the Derivatives market? a) Yes b) No 80% 70% 60% 50% 40% 30% 20% 10% 0% Yes No Comment: Majority believe that necessary steps are not being taken to make people informed about the concept of Derivatives and trading of Derivatives in India.

7) Do you think that awareness programmes about Derivatives should be initiated at college level? a) Yes b) No 80 70 60 50 40 30 20 10 0 Yes No Comment: Majority believed that as steps are not being taken to make people aware about Derivatives. : 0190 Page 59 . Jai Kumar Dungarwal Roll No. awareness programmes and seminars should be conducted at college level so that there is adequate idea about Derivatives.

 From the turnover of the derivative market we can find that Derivative market is growing at a higher pace in India and is increasing year by year. • Introducing adequate risk management and internal monitoring techniques to curb unnecessary speculation so as to protect the interest of small investors.  Thus in outline. : 0190 Page 60 . Derivative Market are more regulated & standardized so in this way it provides a more controlled environment.  There should be the rapid development of derivatives products in financial markets all over the world but with some consciousness. project report establishes knowledge of different strategies and how hedging can be used as an effective tool for investors.11. It encourages the investor to take more risk & earn more return.e. whether they want to hedge the whole portfolio or part of the portfolio. Few developments may be like this: • Introducing more types of risk hedging contracts. Jai Kumar Dungarwal Roll No. So. These strategies are effectively used for hedging loss or gaining risk-free returns by arbitrage and provide good knowledge of when to use these strategies in most effective way according to different market situation. The understanding of payoff patterns of futures and options has contributed to knowledge of implementation of strategies. SEBI should take necessary steps for improvement in Derivative Market so that more investors can invest in Derivative market. SUGGESTIONS:  After the study it is clear that Derivative influence our Indian Economy up to much extent. They can hedge their position in the market by various put and options involved strategies as well as futures.  Investors can use equity derivatives instruments to hedge themselves against the losses of their portfolio as per the risk appetite of the investor and hence they decide the hedge ratio i. FINDINGS & SUGGESTIONS: FINDINGS:  The result of the study is a good understanding of different strategies in derivatives.

easy trading can be done in the commodities segment without incurring storage costs. Airline Companies can hedge themselves by using futures to mitigate risk of risk in ATF Prices. : 0190 Page 61 .  Awareness programmes must be initiated at college levels and also through seminars and through newspapers. As the growth of Derivatives contributes significantly to the economic growth of a nation. there is always a risk of the rise in the prices of Airline Turbine Fuel (ATF). Jai Kumar Dungarwal Roll No.• More awareness must be created among the investors about various derivatives so that investors can enter in to derivatives contract and can make profits by less investment. Indians should be made more informed about this market and thus it shall lead to the growth of both this market as well as the growth of Indian Economy. • A speculator who believes that Gold is overvalued can short Gold and thus gain if his belief turns out to be true. • Entering into commodities’ trading is expensive but through the use of futures and options.  Derivatives can find its use in many areas: • In the Airline Industry.

 This study attempts to simplify the concept of these basis strategies with the knowledge of market condition and payoff strategies so that investor can make out opportunities for reducing the loss and gain fair returns. but most important are hedging and arbitrage.  Financial Derivatives have earned a well-deserved and extremely significant place among all the financial instruments due to innovation and landscape. Derivatives are used for variety of purposes. CONCLUSIONS  The Indian Capital Market has undergone qualitative changes in the last decade due to phenomenal growth of derivatives. yet there is unequitable distribution of information regarding this market.  Derivatives has grown in India at a far greater pace than the growth of its counterparts globally but although the growth of Derivatives in India is at a rapid pace.11. Jai Kumar Dungarwal Roll No. : 0190 Page 62 .

com/content/ncfm/sm_otsm.nseindia. (2003).sharekhan. Tripathy.. : 0190 Page 63 .com>.com>. Reports Studied: Nath Golaka C. BIBLIOGRAPHY Study of derivatives and various instruments has been done with the help of websites. PP. “Future and Options markets”. 261-282 NCFM Derivatives Dealers module. 2002.com www. <www.P.. A. Shenbagaraman. NSE Working Paper. New Delhi. S. "Behavior of Stock Market Volatility after Derivatives". N.eurojournals. Jai Kumar Dungarwal Roll No. PHI Learning Private Ltd.com www.nseindia. PP. Hull.nseindia.gov. 1-169.12.nseindia. Hedging with Index Futures Contract".com>. Thenmojhi M. Kumar.appliedderivatives..derivativesindia. Websites: www.pdf www.in www. "Do Futures and Options Trading contributes to Stock Market growth?” <www. <www. 2009. Vashishtha.equitymaster.com www. PHI Learning Pvt. books and reports. “Financial Services”. Books: John C.com Search engine google. New Delhi. <www. “Development of financial derivatives market in India – a case study”. 3rd Pr.com>.com and Wikipedia. "Futures and Option Trading.. Ltd. 2nd edition.sebi. (2004). Premlata.